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Not long ago, the price for a barrel of crude was $110, and a gallon of regular gasoline would set you back nearly $4. While consumers wished for relief, politicians hunted scapegoats on Wall Street.

After declining 30 percent to $80 a barrel, one might suggest that the politicians who recently pinned high prices on speculators pen a note thanking them for their change of heart. Of course, any such suggestion would be silly. Speculators are no more deserving of praise today than they were deserving of politicians’ scornful derision this spring.

It’s true that through their trades speculators collectively set oil prices, but their actions are driven by expectations of how the fundamentals of supply and demand are likely to develop. If demand grows just a tick faster than supply, prices will jump, and if supply grows slightly faster than demand, they will plummet.

Everyone across the supply chain has been wishing for fuel price pressures to ease, but the recent price drop reflects the expectation that the world’s major economies are in difficulty - a fact which may have an even greater impact on logistics than high fuel prices.

Traders know that nothing is more highly correlated with oil consumption than economic activity. Back in the spring, the U.S. economic recovery was strengthening. Between December and April, the unemployment rate had declined from 8.5 percent to 8.1 percent, and it was expected to keep declining.

Meanwhile, China appeared to be successfully navigating a soft landing, and the OECD forecast of future economic activity improved. Elsewhere in Asia, Japan’s tsunami-ravaged economy grew. Perhaps most importantly, fears of a Eurozone recession eased after the European Central Bank (ECB) flooded the system with cash.

The majority of analysts expected these trends would to continue to lift oil demand, and on the supply side of the equation, a potential armed conflict with Iran loomed large on the collective psyche. Prominent analysts predicted that conflict with Iran would cause oil prices to jump to $180 or more.

The writing was on the wall: If the economic prognostications were correct, oil markets were going to remain tight, and the threat of conflict with Iran was priced into the market.

The outlook today could hardly be more different. The U.S. unemployment rate has ticked back up, and the growth rate of GDP has slowed significantly. China’s soft landing has hit turbulence, and the Euro debt crisis has taken a turn for the worse and is threatening to spiral out of control. Are these just speed bumps, or has the world economy gone off road?

Greece continues to dance dangerously close to default, and thus far the proposed solutions—austerity and euro bonds—have failed to do anything but buy time. It should now be clear that austerity is incapable of addressing the core issue, which is the disparity in productivity levels between Greece and Germany, with the latter country benefitting the most from membership and dominating negotiations among members of the European Union.

By definition, austerity is the reduction of spending combined with increased taxes. Austerity may be effective at reducing federal deficits, but it also robs the Greeks of their purchasing power, and consumer spending is the largest component of GDP.

With the economy in recession, Greece’s current debt load is unmanageable. Growth is required to pay down debt, but growth will remain stalled unless productivity increases or the country’s terms of trade shift such that Greek exports become competitive.

Being tethered to the Euro, Greece can’t devalue their currency in order to make exports more competitive, and boosting productivity requires investment loans. Greece’s high borrowing costs and federal deficit are, in fact, the only issues that are addressed by austerity, euro bonds, and bailout loans.

Euro bonds have been proposed as a solution to the problem of high borrowing costs that reflect the risk of a Greek default. Because all the countries that comprise the monetary union back the euro bonds issued by the ECB, the risk of default and borrowing costs are greatly reduced.

In theory, this sounds reasonable, provided that the amount of euro bonds is sufficient to the task. Unfortunately, the Greek crisis is not unique. Borrowing costs for Italy and Spain, the third and fourth largest economies in the EU, are more than eight times higher than they are in Germany and they are rising. In Ireland they are more than tenfold higher, and in Portugal they are roughly 15 times the German rate.

If the economic and/or fiscal outlook in these other countries turns further south, and there are indicators that they will, borrowing costs will increase, as will the demand for euro bonds.

Because the underlying problem of low productivity is not being addressed, and austerity acts as a great weight on GDP, we should expect the European crisis to worsen before it improves.

The magnitude of the oil price decline indicate that traders believe that both the probability and magnitude of a Eurozone recession are on the rise. In turn, a Eurozone recession will drive down imports from emerging markets exacerbating the challenges already faced, thus the outlook for oil demand in both the Eurozone and emerging markets has been downgraded.

U.S. banks are not immune to the contagious impacts of a major sovereign default, and U.S. economic output is not invulnerable to a Eurozone recession.

In addition to these challenges, the U.S. debt-to-GDP ratio is roughly equivalent to Ireland and Portugal, thus some have insisted that the U.S. impose domestic austerity measures on itself. But drawing comparisons between the U.S. and Greece, et. al, ignores an important fact - U.S. debt is (still) viewed as a safe haven. Consequently during ‘risk on’ periods, investors demand U.S. bonds, and demand has pushed U.S. borrowing costs to all-time lows.

While U.S. federal deficit spending is a great cause for concern, and one that will eventually need to be addressed, voluntary austerity at this point would have detrimental effects on both consumer spending and confidence. If the Bush-era tax cuts are allowed to expire at the end of the year, and the $1.2 trillion in automatic spending cuts are triggered, the U.S. economy will most certainly fall back into recession.

From the perspective of an oil trader, the global oil demand outlook has grown exceptionally soft. Meanwhile, on the supply side, tensions with Iran have been reduced from a boil to a simmer, and more Iranian oil may soon find its way to the market.

Elsewhere in the Middle East, Iraqi production recently reached 3.4 million barrels per day—a level that was last seen in 1979—and Saudi Arabia has lifted production over 10 million barrels per day—a higher rate than in 2008 when prices hit $150 per barrel. Further to the west, the recovery of Libyan oil production to pre-revolution levels has beaten all but the most optimistic projections.

On the other side of the pond, the U.S. is enjoying a surge in production, which has been driven by the production of shale oil, and drilling permits in the Gulf of Mexico have surged this year rising to pre-Macondo levels.

In short, the supply picture has turned decidedly rosy—at least from an oil price perspective. Weak oil markets and low prices could persist for quite some time. Consumers are getting what they wished for, and falling fuel prices are obviously welcome by logistics managers. But if the traders are correct, falling oil prices are a harbinger of more difficult times to come.

About the Author

Derik Andreoli

Derik Andreoli, Ph.D.c. is the Senior Analyst at Mercator International, LLC. He welcomes any comments or questions, and can be contacted at .(JavaScript must be enabled to view this email address).

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